A Business Process Approach

1 - 1Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall

Financial Accounting: A Business Process Approach


Chapter 1

Business: What’s It All About?


Chapter 1 Learning Objectives

When you are finished studying Chapter 1, you should be able to:

1. Describe what a business does and the various ways a business can be organized.

2. Classify business transactions as operating, investing, or financing activities.

3. Describe who uses accounting information and why accounting information is important to them.


Chapter 1 Learning Objectives

4. Identify the elements of the four basic financial statements—the income statement, the statement of changes in shareholders’ equity, the balance sheet, and the statement of cash flows, explain the purpose of each, and be able to use basic transaction analysis to prepare each statement.

5. Identify the elements of a real company’s financial statements.

6. Describe the risks associated with being in business and the part that ethics plays in business.


Ethics Matters

1. Is it legal?

Should Bernie Madoff have asked himself these questions?

2. Will it harm anyone?

3. Would you mind reading about your decision in the morning newspaper?


Purpose of a BusinessLearningObjective 1

2. Add value

3. Sell to customers

1. Obtain capitalObtain the resources needed to

start and run a business


Purpose and Organization of a Business

For-profit firms . . .

Make profits for investors.

Not-for-profit organizations . . .

provide goods and services to people and use profits to provide more goods and

services to people.


Simple Business Model

Cash from Capital, Financing, Property, Plant, Equipment,Raw Materials,Labor,Inventory,Goods & Services

Product

Service

Value-addedconversion

INPUTS

OUTPUTS


Nature of Business Operations

Service : Provide services for customers Financial Services deal in services related to money.

Sales Merchandising—buys goods and resells them to other businesses (wholesale) or to final customers (retail) Manufacturing—makes a product and sells it to other businesses (wholesale) or to final consumers (retail)

Types of Companies:


Your Turn 1-1

What is the main purpose of a business?

The main purpose of a business is to make a profit, increasing the value of the company for the owners.

What are the four general types of businesses?

Service company

Merchandising company

Manufacturing company

Financial services company


Ownership Structure of Businesses

Sole Proprietorship--a single owner business

Partnership--a multiple-owner business

Corporation-a business whose ownership is divided into "shares" and may be owned by a large number of people.

More than 2/3 of U. S. businesses are sole proprietorships.

More than 2/3 of U. S. companies’ profits are earned by corporations.

Only 2.5% of U. S. businesses are partnerships, and they earn less than 10% of all U. S. firms’ profits.


Characteristics of Different Forms of Business

Government regulation

Personal liability

Taxation

Transfer of ownership

Ability to raise capital

1Liability 2 Taxation3 Ownership4 Capital5 Regulation


Sole Proprietorship

Personal responsibility and liability

Income reported on individual’s tax return

Owned by one individual

Difficult to acquire capital

Minimal government regulation


Partnerships

Partners share personal responsibility and liability

Income IS reported on each partner’s individual tax return

Partners usually create an agreement that describes how much work each will do and how the profit and loss will be divided.

Difficult to acquire capital

Minimal government regulation


Corporations

Provides stockholders with limited liability.

A corporation is a popular form of business because . . .

Individuals can purchase small amounts of stock.

Allows for easy transfer of ownership.

More than two-thirds of U.S. firm’sprofits are made by corporations.


Corporations

A corporation is a separate legal entity that can . . .

Own assets

Incur liabilities

Sue and be sued

Enter into contracts

Once the state issues a charter, the stockholders elect a board of directors.


New Hybrid Forms of Business

LLPLimited Liability

Partnership

LLCLimited Liability

Corporation

Have characteristics of both corporations and partnerships

Limited Liability of a corporation

Tax advantages of a partnership

Mostly used by law, medical, and accounting profession


Your Turn 1-2

What are the three major forms of business ownership?

From the owners’ point of view, what are the advantages and disadvantages of each form of

ownership?

The three major forms of ownership are:(1) sole proprietorships (single owner)

(2) partnerships (multiple owners) (3) corporations (widespread ownership)

Advantages: Sole Proprietorship and Partnership:

Owner control, single taxationCorporation:

Limited Liability, Ease of raising capital

Disadvantages: Sole Proprietorship and Partnership:

Liability, Difficulty to raise capitalCorporation:

Conflict of interest between management and owners,

Double taxation


Business Transactions

OperatingActivities

InvestingActivities

FinancingActivities

LearningObjective 2

Business transactions are economic exchanges classified as:

Transactions related to

the generaloperations of

the firm

Transactions related to

buying andselling items the

firm willuse for more than a year

Transactions that deal

with how abusinessgets it

funding


How a Business Works

Sara contributes$5,000 of her own money to start her

business.

Team Shirtsborrows $500from Sara’s

sisterto help financethe business.

Team Shirtspurchases

100 T-shirts froma T-shirt maker.

Team Shirtsdecides to

advertise thenew business.

Team Shirts

sells 90 T-shirts.

Team Shirtsrepays

the loan plusinterest to

Sara’sSister.

Transactions for Team Shirts’ First Month of Business


Information Needs of Decision Makers

• Revenue from sales• Expenses incurred• Net income• Inventory• Reliability of Vendors

LearningObjective 3


Operating Cycle

Start with cash

Purchaseinventory

Collect cashfrom

customers

Make sales to customers

End with more cash


Who Needs Accounting Information?

ManagementThose with direct financial interest

Current or potential investors Current or potential creditors Employees

Those with an indirect financial interest Tax Authorities Regulatory Agencies Economic Planners Labor unions, financial advisors,

others.


Your Turn 1-4

What are revenues and expenses?

What are the four basic financial statements?

Revenues are the amounts a company earns from providing goods or services to its customers.Expenses are the costs to earn those revenues.

The four statements include the income statement, balance sheet, statement of changes in shareholders’ equity, and the statement of cash flows.


Who Sets the Guidelines?

Securities and Exchange Commission (SEC):Created by the U.S. Congress in 1934 to set the rules for corporations that trade on the public stock exchanges.

Public Company Oversight Board (PCAOB)

Financial Accounting Standards Board (FASB)

Mandated by the Sarbanes-Oxley Act.

Created by the SEC in response to 2001- 2002 accounting scandals to oversee audits of public

companies.

The SEC delegates much of the Accounting standard-

setting responsibility to the FASB. SEC retains and sometimes exercises its rights to set standards.

Generally Accepted Accounting Principles Auditing Standards


International Financial Reporting Standards

International guidelines for financial reporting, used in many places around the world.

International Accounting Standards Board (IASB) sets international financial reporting standards.

The SEC plans implementation of IFRS in the United States by 2014 so that one global set of standards is used by all major economies.


Statement of Changes in Owner’s Equity Beginning equity + Contributions +/- Net income/loss - Dividends = Ending equity

Four Basic Financial Statements

Balance Sheet Assets = Liabilities + Equity

Income Statement

Revenues - Expenses = Net income

Statement of Cash Flows

Cash inflow - Cash outflow = Net cash flow

Accountants communicate financial information in the form of four basic financial statements.

LearningObjective 4


Financial Statements

Dates of Financial Statements are Important!

The Balance Sheet is prepared “AS OF…” or “AT” a particular date, a “snapshot” in

time.


Financial Statements

1. The Income Statement 2. Statement of Changes in Owner’s Equity3. Statement of Cash Flows

cover a period of time:“FOR THE PERIOD ENDING”


Balance Sheet

Assets = Claims

Assets = Liabilities + EquityThings of

valueSomething owed

(creditors’ share of the assets)

Net Assets

(owner’s share of the assets)Economic

resources owned

Obligations/debt

Contributed Capital

Retained Earnings


Your Turn 1-5

What are the two parts of Shareholders’ Equity?The two parts of shareholders’ equity are contributed capital and retained earnings (earned capital).

What is a fiscal year?A fiscal year is a year in the life of a business for

financial reporting purposes. It may beginat any time and ends a year later.


Accounting Equation

Contributed Capital Retained

Event Cash All other assets Account Account Common Stock Earnings

1 5000 5000

2 500 500 Note Payable

3 (400) 400 Inventory

4 (50) (50) Expense

5 900 900 Revenue

(360) Inventory (360) Expense

6 (505) (500) Note Payable (5) Expense

7 (100) (100) Dividends

Balances 5345 40 5000 385

Team Shirts

All Liabilities +Assets

Shareholders' Equty

--Income Statement, --Statement of Changes in Shareholders’ Equity, --Balance Sheet, --Statement

of Cash Flows


Income Statement

The amount earned from

providing goods or services to customers

Costs incurred to generate revenue

Difference between

revenues and expenses

. . .describes the activity of

a company during a period

Also called: Statement of

earnings, statement of operations, profit and loss statement

Revenue – Expenses = Net Income


Your Turn 1- 6

What is included on the income statement? What is included on the balance sheet?

Describe the difference in the time periods captured by the income statement and the balance sheet.

The income statement contains revenues and expenses. The balance sheet contains assets,

liabilities, and shareholders’ equity.

The time period captured by the income statement is an accounting period, often a fiscal year. The statement covers a period of time. On the other hand, the balance sheet describes the financial position of a company at a given point in time.


Statement of Changes in Owners’ Equity

Contributed Capital:

Contribution by investors to obtain ownership in a

corporation.

Ownership is divided into shares of stock.

Total of all net income earned by the business

MinusDividends Paid to owners (Distributions to

owners)

Beginning balance +/- changes in contributed capital+/- changes in retained earnings = Ending balance

Retained Earnings:



Cash from Operating Activities

Cash from Investing Activities

Cash from Financing Activities

From customers’ purchases,

interest or dividend income

Cash Inflow

From sale of property

and equipment

From issuinglong-term debtor issuing stock



Cash Outflow

Cash from Operating Activities

Cash from Investing Activities

Cash from Financing Activities

To suppliers for inventory,

For employees’ salaries

To purchase plant and

equipment,Investments in

other firms

To repay long-termdebt principal,

To pay dividends to owners


Your Turn 1 - 7

How is the income statement related to the balance sheet? In other words, how does the amount of net income affect the balance sheet?

Why is it necessary to have both an income statement and a statement of cash flows?Look at the statements for Team Shirts and explain why they are different.

The income statement gives the revenues and expenses for the period. The net amount, net income, is added to

retained earnings. So the income statement number becomes part of the retained earnings total on the

year-end balance sheet.

The income statement shows all revenues and expenses for a period of time—all the revenues that have been earned and expenses incurred to earn those revenues. The statement of cash flows simply lists the cash inflows and outflows during the period. Also, any transactions with owners (contributions and dividends) are not included on the income statement.


Revenues -Expenses Net income

LearningObjective 5

Real Company’s Financial Statements

Single-step: Groups all revenues

together and deducts all

expenses from total revenues

Revenues - Cost of Goods Gross Margin + Other Revenue

- Other Expenses

Operating Income - Income Taxes Net

Income

Multi-step: Calculates net

income in steps

Income Statements


Shows a subtotal for various classes of assets and liabilities, including current and long-term assets and liabilities, and shareholders’ equity

Real Company’s Financial Statements

Assets:

Current Assets

Property, Plant, and Equipment

Other Assets

Shareholders’ Equity:

Contributed Capital,

Retained Earnings,

Other Comprehensive

Income

Liabilities:

Current Liabilities

Long-term Liabilities

Classified Balance Sheet


Risk: Anything that exposes us to potential injury or loss.

Can turn into significant losses, scandals, or total company failure.

LearningObjective 6

Business Risk, Control, and Ethics

Product Failure

Theft of Assets

Purchase/sale of poor quality

inventory

Strategic Risks

Operating Risks

Financial Risks

Information Risks


Control: An activity performed to minimize or eliminate risk. A firm must establish and maintain control over its operations, assets, and information systems.

Business Risk, Control, and Ethics

Every risk brings a potential reward.

Firms’ managers want to minimize risks.

A manager must always put good ethical behavior above putting a good face on the firm’s financial position or performance.


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Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall

Economy & Finance

A Business Process Approach